In Part 1 of Fellow Travelers, an ImpactAlpha series, we explored the divergent paths of impact investing and emerging markets. In Part 2, we dig into the data on impact capital flows and investment returns in less-established markets.

Scope

Developed markets account for roughly half of the $113.7 billion in impact investments, according to the 2017 benchmark survey from the Global Impact Investing Network. While the emerging markets field is growing in general — with sub-Saharan Africa in the lead, developed markets will likely maintain their lead over emerging markets.

There are substantial differences between emerging markets and developed markets in terms of the investee’s stage of development and sector.

Of the assets going to emerging markets, there is a clear and growing focus on growth stage businesses (47%). That may bode well for the development of job and economic growth-creating SGBs over the long-term.

Slightly less than half is being invested in mature or publicly traded companies, which, while important, are not the net generators of jobs. There appears to be a strong preference for Private Debt (62%) over Private Equity (27%) in emerging markets. But this may not be as clear as it seems – 42% of global Private Debt went toward microfinance. Given the predominance of microfinance in emerging markets, it is likely that a significant portion of emerging market’s Private Debt is going toward microfinance.

That means small and growing businesses are still relying on Private Equity investments. In general, equity investments are not conducive to SGB growth. Equity requires an exit. Most emerging markets lack liquid markets and the mechanisms for traditional exits (trade sales or going public events). SGB, in emerging markets, also tend to be multi-generational. As one lawyer who does significant work with SGBs in emerging markets recently told us:

“Equity is like a partnership. If I am a mid-sized business owner, the last thing I want is another partner. I probably already have my cousin, my aunt, my mother and three brothers in the business. I don’t need someone else telling me what to do.”

The news doesn’t get much better when we break the investments down by sector. The 40% of investees in microfinance are not a small and growing businesses, and are unlikely to be able to scale dramatically, if at all. Beyond microfinance, it is not clear to what extent the remaining 60% of AUM is being invested in small and growing businesses versus other entities that may not share SGBs’ scalability in terms of job creation and economic growth, regardless of their level of impact.

Indeed, the more one digs into impact investing, the less capital is actually directed toward potentially game-changing sectors and the small and growing businesses within emerging markets that are key to these states’ economic development. Instead of helping to drive a new generation of small and medium-sized goods and services providers integrated into global supply chains, much of impact investment appears to be directed toward efforts to ameliorate the status quo, not change it.

Returns

While the expectation of a return is implicit in any impact investment — otherwise it is a grant — the rate of return can range widely. BlackRock Impact, for example, invests only a small portion of its capital in what could be called impact investments. And even that is focused on liquid, market-rate of return providing investments. While there may be some market-rate- producing SGB investments in emerging markets, they are neither the majority nor particularly liquid. Consequently, it is unlikely that BlackRock Impact has invested in many emerging markets SGBs, if it has at all.

Within emerging markets at large in 2017, 60% of investors sought risk adjusted market rate returns. One-quarter expected close-to-market returns. And 17% simply wanted a rate of return closer to capital preservation. According to a benchmark developed by Cambridge Associates (2016 figures), for equity investments, average emerging markets market rate return expectations were 16.8% and below market-rate return expectations were 11%.

Emerging markets Private Equity (PE) and Venture Capital (VC) impact investing funds launched between 1998–2004, have a net IRR of 15.5%. However, more recent vintage funds tell a different, but nonetheless interesting, story. Emerging market PE and VC funds have underperformed return expectations for over a decade, only surpassing the 16.8% market rate of return expected by investors for funds started between 1998 and 2001.

For 2011–2014 vintage funds, the return has been particularly poor, -7.93%. In our experience, investors tend to be data focused, and the data around emerging markets PE and VC (the priority for SGBs) is not encouraging: Those that have invested have been disappointed and those that are considering investing, would be ‘fighting the tape.’

If we compare funds by size (smaller or greater than $100 million), it becomes clear that smaller funds tend to significantly outperform lager funds, which may reflect the difficulty of conducting extensive due diligence on or sourcing of the many investments required to allocate an entire large fund to investments like emerging markets SGBs. It could also reflect the lack of a sufficient quantity of investment-ready SGBs in individual countries, requiring the expensive expansion to multiple target countries.

Fellow Travelers, Part 1: Bringing emerging markets and impact investing back together